McMaster University ECON 3C03 Public Sector Economics Essay

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ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Empirical Incidence Studies Tax Incidence with a Mobile Factor Application to European soccer players • From our theoretical analysis, we expect that mobile factors of production will be very sensitive to taxes and bear little of the tax burden • Example: high ability football/soccer players Tax Incidence with a Mobile Factor Application to European soccer players Two policy changes in Europe allowed researchers to study how taxes affect the market for top soccer players 1. 2. The 1995 Bosman ruling lifted the cap on foreign-born players on European club teams. This made it easier for foreign players to sign with teams in low tax European countries Spain’s 2004 “David Beckham rule” allowed foreign workers living in Spain to pay a lower tax rate. All else equal, this policy made Spanish teams more attractive for top European soccer players Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Empirical Incidence Studies Average Tax Rate, Total Taxes, by Broad Income, Canada, 1990 to 2005 Figure 14.12 14-12 Empirical Incidence Studies Decile Cut-offs, 1990 and 2005 (in constant 2010 dollars) Table 14.3 14-13 Empirical Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005 Figure 14.13 14-14 Empirical Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005 Figure 14.14 14-15 Chapter 14 Summary • Statutory incidence refers to the legal liability for a tax, while economic incidence shows the actual sacrifice of income due to the tax. • Economic incidence is determined by the way price changes when a tax is imposed; the incidence of a tax ultimately falls on individuals via both their sources and uses of income. • In partial equilibrium competitive models, tax incidence depends on the elasticities of supply and demand. • Due to capitalization, the burden of taxes may be borne by current owners of an inelastically supplied durable commodity, such as land. 14-16 Chapter 14 Summary (cont) • Applied incidence studies indicate the Canadian system is progressive up to the middle of the income distribution, then modestly regressive thereafter. 14-17 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Who pays taxes? Now that we know how to measure the progressivity of the tax system we can start thinking who actually pays taxes in Canada (or any other country for that matter). It turns out that this is a complicated question to answer. Consider the following example from the textbook. Suppose that the price of a wine bottle is $10. The government imposes a tax of $1 per bottle sold. The tax is collected by firms as the government requires that stores must pay $1 to the government for each bottle sold. Who pays this tax? Three (out of many) possible scenarios. • • • The price of a wine bottle rises to $11 The price of a wine bottle stays at $10 The price of a wine bottle rises to $10.30 LO1 Tax Incidence Vocabulary • Statutory Incidence: the party that is legally responsible for paying the tax (firms in our wine bottle example) • Economic Incidence: who actually pays for the tax, as measured by the change in the distribution of private real after-tax incomes. • Tax Shifting: the transfer of the burden of paying the tax from those that are legally liable for it to others due to equilibrium price changes • Forward shifting: the transfer of a tax burden from sellers who are legally liable to buyers through higher prices of the taxed good • Backward shifting: the transfer of a tax burden from buyers who are legally liable to sellers through lower prices of the taxed good 14-6 Tax Incidence Vocabulary • Unit tax: a tax that is a fixed dollar amount per each unit of the good bought/sold ! =#+% • Ad-valorem tax: a tax that is a fixed percentage of the price of a good ! = # + &# = #×(1 + &) Tax Incidence: General Remarks • Only people can bear taxes • Businesses (whatever their legal form) do not pay taxes. It is the owners of the business (shareholders, partners) that pay the tax • Taxes and the functional distribution of income • Studies the impact of taxes on how income is distributed across different factors of production (i.e. owners of capital, labourers, landlords) • This analysis answers the question: does a particular tax affect owners of capital more than labourers? • Taxes and the size distribution of income • Studies the impact of taxes on how income is distributed among people (i.e. those in the top 1%,, bottom 20% etc…) 14-8 Tax Incidence: General Remarks • Both sources and uses of income should be considered • Consider the wine example from a few slides ago • Suppose wine is disproportionately consumed by the poor but that the vineyards are owned by the rich • Ignoring the effects of taxes on the sources side when considering a commodity tax can be misleading (same applies if ignoring the effects on the uses side when considering a tax on an input) • Incidence depends on how prices are determined • Tax incidence depends on how taxes affect market prices • How prices are determined in perfect competition is very different from how prices are determined in a monopoly or oligopoly • We will study both 14-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Partial Equilibrium Models • Models that look only at the market in which the tax is imposed and ignore the ramifications in other markets 14-5 Price per litre of wine Unit Taxes on Commodities Price and Quantity Before Taxation a Pa Sw u b P0 m Pc u n Dw Figure 14.1 Qa Q0 Qc Litres of wine per year 14-6 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Demand Side Sw Pg P0 Pn u D’ Figure 14.2 Q1 Q0 Dw w Litres of wine per year 14-7 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Demand Side Tax Revenue = kfhn Price paid by consumers Original price Price received by producers Pg P0 Pn k f m n Sw Tax wedge = fh g h u D’ Figure 14.2 Q1 Q0 Dw w Litres of wine per year 14-8 Important Results/Concepts Unit Taxes on Commodities • Economic incidence does not depend on whether it is levied on consumers or producers • This is called the irrelevance of statutory incidence result in public economics • Economic incidence depends on elasticities of supply and demand • Elasticity of demand: !" = − • Elasticity of supply: !0 = % &'()*+ ,) " % &'()*+ ,) - % &'()*+ ,) 0 % &'()*+ ,) - = =− ." .- × " .0 × .0 14-9 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Supply Side Price paid by consumers Original price Price received by producers S’ j P’ u w Sw Pi gP 0 P’ n Dw Figure 14.3 Q’1 Q0 Q1 Litres of wine per year 14-10 Unit Taxes on Commodities LO4 Price per litre of X Tax Incidence when Supply is Perfectly Inelastic SX Pg=P0 u Price received by suppliers falls by the full amount of the tax Pn Dx D’x Figure 14.4 X per year 14-11 Unit Taxes on Commodities LO4 Price per litre of Z Tax Incidence when Supply is Perfectly Elastic Pg Price paid by consumers increases by the full amount of the tax u Pn=P0 Sz Dz D’z Figure 14.5 Z1 Z0 Z per year 14-12 Formula for the effect of a unit tax on the market price paid by buyers !ℎ#$%& '$ ( ∆( &, = = !ℎ#$%& '$ ) ∆) &, + &. The buyer bears a greater burden if the seller is more elastic than the buyer ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Price per unit of clothing Ad Valorem Taxes Ad-valorem taxes shift the perceived demand curve down by the same proportion at all points. In this example, the tax levied on buyers shifts perceived demand down by 25%. Sc r Pr s P0 m Pm n Dc Qr Q0 Qm Units of clothing Figure 14.6 14-5 LO4 Ad Valorem Taxes Price per unit of clothing Incidence of an Ad Valorem Tax S’c Sc Pg P0 Pn Q1 Q0 Dc D’c Units of clothing Figure 14.7 14-6 Can we tell from this pay stub how much tax Joseph Mayer paid? Taxes on Factors of Production • The payroll tax • Tax on labor used to finance the Canada Pension Plan (CPP) • In 2019, workers pay a CPP payroll tax of 5.1% of their earnings between $3,500-$57,400 • Employers pay the same 5.1% rate for each worker • The reason why employers and workers pay the same rate is because politicians have long felt that the payroll tax burden should be shared between firms and workers. • What does our analysis of tax incidence tell us about who “pays for” the CPP payroll tax? 14-8 LO4 Wage rate per hour The Payroll Tax SL Pr wg = w0 wn DL DL’ Figure 14.8 L0 = L1 Hours per year 14-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Commodity Taxation with Imperfect Competition • Monopoly • Despite market power a monopolist is generally made worse off • • • • Quantity demanded goes down Price paid by consumers goes up Price received by the monopolist goes down Profits go down • Oligopoly • Can result in higher or lower profits 14-4 Equilibrium of a Monopolist $ Economic Profits MXX P0 ATC0 c d a ATCX b DX MRX Figure 14.9 X0 X per year 14-5 Imposition of a Unit Tax on a Monopolist $ Economic Profits MXX c P0 Economic Pn i Profits dh after unit tax ATC0 a f g ATCX b DX MRX X1 X0 MRX’ DX’ X per year Figure 14.10 14-6 Taxes on Profits LO5 • Economic profit: the return to the owners of a firm in excess of the opportunity costs of the factors used in production (also called supranormal or excess profits) • Perfect competition • Short run: a tax on profits doesn’t change MR or MC so output and prices paid by consumers doesn’t change. Owners of the firm bear the full burden of the tax • Long run: economic profit is zero so a profit tax yields 0 revenue • Monopoly • The monopolist bears the whole tax. The intuition is similar to the one for profit taxes in a perfectly competitive market in the short run 14-7 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Taxes on Land • Let’s look at a tax on land. Suppose Rt is the annual rental income on land in year t and that the market for land is competitive • Also assume that the land will be economically useful for T years • Question: What price should buyers be willing to pay for the land? 14-4 Taxes on Land • Question: What price should buyers be willing to pay for the land? $%( $%+ $%/ !" = $%& + + + ⋯+ + 1 + * (1 + *) (1 + *)/ PR is the present value of the income the owner of the land will receive. 14-5 Taxes on Land Now suppose that the government announces a tax will be imposed on land. The tax payment is u0 in year 0, u1 in year 1 and so on… Question: what will the new price of land be? 14-6 Taxes on Land Now suppose that the government announces a tax will be imposed on land. The tax payment is u0 in year 0, u1 in year 1 and so on… Question: what will the new price of land be? !"# $('- − *-) $('0 − *0) $('2 −* 2 ) = $('( − *() + + + ⋯+ 0 1+/ (1 + /) (1 + /)2 14-7 Tax Incidence and Capitalization After the introduction of the tax, the price of land falls by !" − !"$ = $'( + $*+ ,-. + $*/ (,-.)/ + ⋯+ $*3 (,-.)3 We say that the present value of the tax liability is capitalized into the price of the asset Capitalization: a stream of tax liabilities becomes incorporated into the price of an asset 14-8 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) General Equilibrium Models • Up to now, we have only been studying the incidence of taxes in partial equilibrium models • Ignoring the feedback of taxes into other markets leads to an incomplete picture of how taxes affect incomes • Example: suppose a tax is levied on all capital used in the construction of housing • Partial equilibrium: the burden of the tax is borne by suppliers and demanders of housing capital. The most elastic party bears the smallest burden • General equilibrium: if the tax lowers the return (i.e. incomes) of suppliers of housing capital, they may choose instead to invest their funds in another sector (e.g. manufacturing, natural resources). But this movement of capital will affect prices in those other sectors. As a result, we will need to measure how prices and the incomes of all other sectors change. General Equilibrium Models • There is very little good empirical evidence on the incidence of taxes in general equilibrium. Why? • Because tracing out the effects of taxes in all markets depends on assumptions about • Consumer preferences (and how they vary across people) • How mobile/fixed factors of production are (short vs. long run answers differ) • Market structure (perfect competition versus imperfect competition) • Production technology • Whether the model allows new goods/services to enter a market ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Who pays taxes? Now that we know how to measure the progressivity of the tax system we can start thinking who actually pays taxes in Canada (or any other country for that matter). It turns out that this is a complicated question to answer. Consider the following example from the textbook. Suppose that the price of a wine bottle is $10. The government imposes a tax of $1 per bottle sold. The tax is collected by firms as the government requires that stores must pay $1 to the government for each bottle sold. Who pays this tax? Three (out of many) possible scenarios. • • • The price of a wine bottle rises to $11 The price of a wine bottle stays at $10 The price of a wine bottle rises to $10.30 LO1 Tax Incidence Vocabulary • Statutory Incidence: the party that is legally responsible for paying the tax (firms in our wine bottle example) • Economic Incidence: who actually pays for the tax, as measured by the change in the distribution of private real after-tax incomes. • Tax Shifting: the transfer of the burden of paying the tax from those that are legally liable for it to others due to equilibrium price changes • Forward shifting: the transfer of a tax burden from sellers who are legally liable to buyers through higher prices of the taxed good • Backward shifting: the transfer of a tax burden from buyers who are legally liable to sellers through lower prices of the taxed good 14-6 Tax Incidence Vocabulary • Unit tax: a tax that is a fixed dollar amount per each unit of the good bought/sold ! =#+% • Ad-valorem tax: a tax that is a fixed percentage of the price of a good ! = # + &# = #×(1 + &) Tax Incidence: General Remarks • Only people can bear taxes • Businesses (whatever their legal form) do not pay taxes. It is the owners of the business (shareholders, partners) that pay the tax • Taxes and the functional distribution of income • Studies the impact of taxes on how income is distributed across different factors of production (i.e. owners of capital, labourers, landlords) • This analysis answers the question: does a particular tax affect owners of capital more than labourers? • Taxes and the size distribution of income • Studies the impact of taxes on how income is distributed among people (i.e. those in the top 1%,, bottom 20% etc…) 14-8 Tax Incidence: General Remarks • Both sources and uses of income should be considered • Consider the wine example from a few slides ago • Suppose wine is disproportionately consumed by the poor but that the vineyards are owned by the rich • Ignoring the effects of taxes on the sources side when considering a commodity tax can be misleading (same applies if ignoring the effects on the uses side when considering a tax on an input) • Incidence depends on how prices are determined • Tax incidence depends on how taxes affect market prices • How prices are determined in perfect competition is very different from how prices are determined in a monopoly or oligopoly • We will study both 14-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Partial Equilibrium Models • Models that look only at the market in which the tax is imposed and ignore the ramifications in other markets 14-5 Price per litre of wine Unit Taxes on Commodities Price and Quantity Before Taxation a Pa Sw u b P0 m Pc u n Dw Figure 14.1 Qa Q0 Qc Litres of wine per year 14-6 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Demand Side Sw Pg P0 Pn u D’ Figure 14.2 Q1 Q0 Dw w Litres of wine per year 14-7 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Demand Side Tax Revenue = kfhn Price paid by consumers Original price Price received by producers Pg P0 Pn k f m n Sw Tax wedge = fh g h u D’ Figure 14.2 Q1 Q0 Dw w Litres of wine per year 14-8 Important Results/Concepts Unit Taxes on Commodities • Economic incidence does not depend on whether it is levied on consumers or producers • This is called the irrelevance of statutory incidence result in public economics • Economic incidence depends on elasticities of supply and demand • Elasticity of demand: !" = − • Elasticity of supply: !0 = % &'()*+ ,) " % &'()*+ ,) - % &'()*+ ,) 0 % &'()*+ ,) - = =− ." .- × " .0 × .0 14-9 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Supply Side Price paid by consumers Original price Price received by producers S’ j P’ u w Sw Pi gP 0 P’ n Dw Figure 14.3 Q’1 Q0 Q1 Litres of wine per year 14-10 Unit Taxes on Commodities LO4 Price per litre of X Tax Incidence when Supply is Perfectly Inelastic SX Pg=P0 u Price received by suppliers falls by the full amount of the tax Pn Dx D’x Figure 14.4 X per year 14-11 Unit Taxes on Commodities LO4 Price per litre of Z Tax Incidence when Supply is Perfectly Elastic Pg Price paid by consumers increases by the full amount of the tax u Pn=P0 Sz Dz D’z Figure 14.5 Z1 Z0 Z per year 14-12 Formula for the effect of a unit tax on the market price paid by buyers !ℎ#$%& '$ ( ∆( &, = = !ℎ#$%& '$ ) ∆) &, + &. The buyer bears a greater burden if the seller is more elastic than the buyer ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Price per unit of clothing Ad Valorem Taxes Ad-valorem taxes shift the perceived demand curve down by the same proportion at all points. In this example, the tax levied on buyers shifts perceived demand down by 25%. Sc r Pr s P0 m Pm n Dc Qr Q0 Qm Units of clothing Figure 14.6 14-5 LO4 Ad Valorem Taxes Price per unit of clothing Incidence of an Ad Valorem Tax S’c Sc Pg P0 Pn Q1 Q0 Dc D’c Units of clothing Figure 14.7 14-6 Can we tell from this pay stub how much tax Joseph Mayer paid? Taxes on Factors of Production • The payroll tax • Tax on labor used to finance the Canada Pension Plan (CPP) • In 2019, workers pay a CPP payroll tax of 5.1% of their earnings between $3,500-$57,400 • Employers pay the same 5.1% rate for each worker • The reason why employers and workers pay the same rate is because politicians have long felt that the payroll tax burden should be shared between firms and workers. • What does our analysis of tax incidence tell us about who “pays for” the CPP payroll tax? 14-8 LO4 Wage rate per hour The Payroll Tax SL Pr wg = w0 wn DL DL’ Figure 14.8 L0 = L1 Hours per year 14-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Commodity Taxation with Imperfect Competition • Monopoly • Despite market power a monopolist is generally made worse off • • • • Quantity demanded goes down Price paid by consumers goes up Price received by the monopolist goes down Profits go down • Oligopoly • Can result in higher or lower profits 14-4 Equilibrium of a Monopolist $ Economic Profits MXX P0 ATC0 c d a ATCX b DX MRX Figure 14.9 X0 X per year 14-5 Imposition of a Unit Tax on a Monopolist $ Economic Profits MXX c P0 Economic Pn i Profits dh after unit tax ATC0 a f g ATCX b DX MRX X1 X0 MRX’ DX’ X per year Figure 14.10 14-6 Taxes on Profits LO5 • Economic profit: the return to the owners of a firm in excess of the opportunity costs of the factors used in production (also called supranormal or excess profits) • Perfect competition • Short run: a tax on profits doesn’t change MR or MC so output and prices paid by consumers doesn’t change. Owners of the firm bear the full burden of the tax • Long run: economic profit is zero so a profit tax yields 0 revenue • Monopoly • The monopolist bears the whole tax. The intuition is similar to the one for profit taxes in a perfectly competitive market in the short run 14-7 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Taxes on Land • Let’s look at a tax on land. Suppose Rt is the annual rental income on land in year t and that the market for land is competitive • Also assume that the land will be economically useful for T years • Question: What price should buyers be willing to pay for the land? 14-4 Taxes on Land • Question: What price should buyers be willing to pay for the land? $%( $%+ $%/ !" = $%& + + + ⋯+ + 1 + * (1 + *) (1 + *)/ PR is the present value of the income the owner of the land will receive. 14-5 Taxes on Land Now suppose that the government announces a tax will be imposed on land. The tax payment is u0 in year 0, u1 in year 1 and so on… Question: what will the new price of land be? 14-6 Taxes on Land Now suppose that the government announces a tax will be imposed on land. The tax payment is u0 in year 0, u1 in year 1 and so on… Question: what will the new price of land be? !"# $('- − *-) $('0 − *0) $('2 −* 2 ) = $('( − *() + + + ⋯+ 0 1+/ (1 + /) (1 + /)2 14-7 Tax Incidence and Capitalization After the introduction of the tax, the price of land falls by !" − !"$ = $'( + $*+ ,-. + $*/ (,-.)/ + ⋯+ $*3 (,-.)3 We say that the present value of the tax liability is capitalized into the price of the asset Capitalization: a stream of tax liabilities becomes incorporated into the price of an asset 14-8 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University January 2021 COST-BENEFIT ANALYSIS Chapter 3 ©2016 by McGraw-Hill Education Limited Outline for Lecture • Economic Efficiency & Distributional Considerations • Present Value • Public Sector Discount Rate • Valuing Public Benefits & Costs Background reading material: RWS Chapter 3 (up to page 52 only) Valuing Public Benefits & Costs LO5, LO6 Valuing Public Benefits and Costs • Use Market Prices? • Use Consumer Surplus? Figure 3.2 3-5 Using Consumer Surplus to Measure the Net Benefits of a Policy Figure 3A.1 3-6 Valuing Public Benefits and Costs LO7 Inferences from Economic Behavior • How to place a value on the time saved by a proposed project like a new highway? • Earnings • Other methods • How to place a value on a life saved by a proposed project such as a 4-lane divided highway? • Lost earnings • Probability of death 3-7 Valuing Public Benefits and Costs Intangibles • Intangibles can subvert cost-benefit exercises • C/B tools can reveal limits on valuing intangibles • Cost-effectiveness analysis might be best in the presence of intangible benefits • Comparing the costs of various alternatives that attain similar benefits to determine which one is the cheapest 3-8 Valuing Public Benefits and Costs LO8 Uncertainty Project Benefit Probability CE* X $1,000 1.00 $1,000 0 0.50 Y $2,000 0.50 $? *Certainty Equivalents (Expected Value) 3-9 Chapter 3 Summary • Cost-Benefit analysis is the practical use of welfare economics to evaluate potential projects. • A project generates a potential Pareto improvement if the gainers can compensate the losers and still enjoy a net increase in utility. • Present value of future expected costs and benefits must be calculated in order to allow correct comparisons. • Although the IRR and B-C Ratio are used to evaluate projects, the NPV criterion has fewer biases and problems. • Choosing the discount rate is critical in cost-benefit analysis. • In public sector analyses, three possible measures are the beforetax private rate of return, a weighted average of before- and aftertax private rates of return, and the social discount rate. 3-10 Chapter 3 Summary (cont.) • The costs and benefits of public projects can be measured using market prices in the absence of market failures; otherwise, shadow prices or consumer surplus can be used. • Quantifying the value of time and life, is necessary in measuring benefits, but using earnings as a proxy has limitations. • Uncertainty of future costs and benefits can be included through the use of certainty equivalents. 3-11 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University January 2021 COST-BENEFIT ANALYSIS Chapter 3 ©2016 by McGraw-Hill Education Limited Outline for Lecture • Economic Efficiency & Distributional Considerations • Present Value • Public Sector Discount Rate • Valuing Public Benefits & Costs Background reading material: RWS Chapter 3 (up to page 52 only) Public Sector Discount Rate Importance of Discount Rates/Discount Factors • We will see how the choice of r – the discount rate – is crucial for determining whether policies/projects should go ahead • Choice of r should reflect the opportunity cost of funds: what return would the funds earn if invested instead of the proposed project/policy • This is much easier to do for private sector projects than public sector projects Private Sector Project Evaluation LO3 Present Value Criteria B1 - C1 B2 + C2 BT - CT PV = B0 - C0 + + + ... + 2 T 1+ r (1 + r ) (1 + r ) Annual Net Return Present Value Year R&D Oil Well r= R&D Oil Well 0 -$1,000 -$1,000 0 $150 $200 1 600 0 0.01 128 165 2 0 0 0.05 46 37 3 550 1,200 0.07 10 -21 Table 3.2 Note choice of r is critical: • Low r benefits Oil Well; High r benefits R&D. 3-6 Private Sector Project Evaluation Internal Rate of Return IRR: Discount rate that would make a project’s PV zero B1 - C1 B2 + C2 BT - CT PV = B0 - C0 + + + ... + =0 2 T 1+ r (1 + r ) (1 + r ) Project Year 0 Year 1 ρ Profit PV X -$100 $110 10% $4 3.77 Y -$1,000 $1,080 8% $20 18.87 This criterion is flawed when comparing projects of much differing sizes. Although X has the higher IRR, Y yields the higher profit. Note that the PV criteria, using r=6%, would prefer Y. 3-7 Private Sector Project Evaluation Benefit-Cost Ratio B1 B2 BT B = B0 + + + ... + 2 T 1 + r (1 + r ) (1 + r ) C1 C2 CT C = C0 + + + ... + 2 T 1 + r (1 + r ) (1 + r ) Benefit-cost ratio = B/C 3-8 Problems with the Benefit-Cost Ratio “Costs or Negative Benefits?” Method I II B $250M $200M C $100M $100M B/C 2.5 2.0 Suppose that $40 of costs need to be added to method I I: Subtract $40M from B? $210M $100M 2.1 $140M 1.79 OR I: Add $40M to C? $250M Benefit-Cost criterion can lead to incorrect inferences 3-9 Private Sector Project Evaluation The Present-Value Criterion is the most reliable evaluation guide • Both IRR and Benefit-Cost Ratio Criteria can lead to incorrect inferences 3-10 LO4 Public Sector Discount Rate • Every dollar spent by the public sector comes from taxes on the private sector • Therefore, some argue that public sector projects should use discount rates based on private sector returns • There are some challenges with implementing this idea • If funds from the private sector would have been invested, using the private before-tax return is correct • E.g. the government raises $1 billion in tax revenue that would have earned a return of 5% if it was invested in the private sector • Problem: not all tax revenue would be invested – some is consumed • How to know how much of the revenue collected would be invested vs. consumed? 3-11 Public Sector Discount Rate • Social Discount Rate (SDR): the rate at which society is willing to trade off present consumption for future consumption • The SDR may be different from the private sector discount rate for several reasons • Concern for future generations • Paternalism • Market Inefficiency ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University January 2021 COST-BENEFIT ANALYSIS Chapter 3 ©2016 by McGraw-Hill Education Limited Outline for Lecture • Economic Efficiency & Distributional Considerations • Present Value • Public Sector Discount Rate • Valuing Public Benefits & Costs Background reading material: RWS Chapter 3 (up to page 52 only) Present Value Present Value • Project evaluation usually requires comparing costs and benefits from different time periods. • What examples can you think of? • The present value of a future amount of money is the maximum amount you would be willing to pay today for the right to receive the money in the future. 3-5 Future Value (FV): Projecting Present Dollars into the Future R=$ T=years r=interest rate How much will $100 earn in 2 years at an interest rate of 5%? R0 = $100 R1 = $100*(1+.05) = $105 R2 = $105*(1+0.05) = $100*(1+.05)2 = $110.25 RT = R0*(1+r)T 3-6 Present Value (PV): LO2 Discounting Future Dollars into the Present How much will $100 earned in 2 years at an interest rate of 5% be worth today? Since RT = R0*(1+r)T Present Value R0 = RT/(1+r)T discount factor discount rate Low r – more future-oriented and benefits projects in which returns are concentrated further into the future High r – more present-oriented and benefits projects in which returns are concentrated closer into the future 3-7 Present Value of a Stream of Money R1 R2 RT PV = R0 + + + ... + 2 T (1 + r ) (1 + r ) (1 + r ) 3-8 Inflation How to incorporate inflation – price level increases – into the procedure? Given: ! = inflation rate (1 + P) R1 (1 + P) 2 R2 (1 + P) T RT PV = R0 + + +...+ 2 2 (1 + P)(1 + r ) (1 + P) (1 + r ) (1 + P) T (1 + r ) T However, (1+ !) terms cancel out, leaving the PV equation from previous slide! CAUTION: $ values and r values must be measured consistently – if real values are used for R, the r must be measured in real terms 3-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University January 2021 COST-BENEFIT ANALYSIS Chapter 3 ©2016 by McGraw-Hill Education Limited Outline for Lecture • Economic Efficiency & Distributional Considerations • Present Value • Public Sector Discount Rate • Valuing Public Benefits & Costs Background reading material: RWS Chapter 3 (up to page 52 only) Economic Efficiency & Distributional Considerations Cost-Benefit Analysis and Welfare Economics • Government intervention often creates “winners” and “losers” • Building a new airport or highway • Introduction of a new tax (e.g. a carbon tax) • Cost-benefit analysis provides a way to put a value on the benefits to the winners and costs to the losers to determine whether a particular policy is worthwhile • Closely related to Welfare Economics discussed in the previous module LO1 Economic Efficiency • When resources are allocated inefficiently, then there is a Pareto improvement available; someone can gain and no one need lose • If the social benefits of a project exceed the social costs, undertaking the project increases the “size of the economic pie” • Beneficiaries can fully compensate the losers and still have some benefits left over, generating a Pareto improvement • The difference between benefits (B) and costs (C) can be regarded as the contribution of a project to economic efficiency • Net Return = B − C 3-6 Efficiency of the Competitive Equilibrium Figure 3.1 3-7 Discussion Question 1 Is a policy that creates both winners and losers a Pareto Improvement over the status quo? a. Yes b. No c. Not enough information to tell Distributional Considerations • Up to now we have only been discussing the evaluation of the efficiency gains of government action (i.e. impacts on the size of the economic pie) • Distributional considerations refer to how the benefits and costs of a particular government action or project differ across people in a society • Two issues • • Compensating the losers from a policy action Welfare weights 3-9 Distributional Considerations Compensating losers from a policy action • If a policy creates winners and losers, then it is not a Pareto improvement. Does this mean the policy should not be undertaken? • If the policy creates a net benefit (i.e. N = B – C > 0) then in principle it is possible for the winners to compensate the losers so that they are not worse off • Hicks-Kaldor Criterion: a project should be undertaken if it has positive net present value, regardless of distributional consequences Distributional Considerations: Welfare Weights • Sometimes policy makers believe individuals in certain groups are especially deserving and assign a higher “welfare weight” on their gains/losses in any cost-benefit calculation • Groups typically defined based on income. Typically, inequality aversion leads to more weight being put on low-income individuals. Weights can depend on more than income, including – Region, the presence of young children, gender Distributional Considerations: Welfare Weights • “The economist as a plumber” • Induce policy makers to make explicit value judgements underlying welfare weights • Help policy makers understand the implications of different policy alternatives • Avoid letting ones own political preferences affect advice given to decision makers Esther Duflo (MIT): Co-winner of the 2019 Nobel Prize in Economics Discussion Question 2 As long as the net benefit is positive, the gainers from a policy can agree to compensate losers and still enjoy an increase in utility. This notion is called a. b. c. d. a potential Pareto improvement the Hicks-Kaldor criterion both of the above are correct none of the above are correct ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University January 2021 Fundamentals of Welfare Economics Chapter 2 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Introduction to Welfare Economics • Introduction to Pareto Efficiency • Theory • Pure exchange economy • Economy with production • First Welfare Theorem • Second Welfare Theorem • Equity-Efficiency Tradeoffs • Individual Failures Market Failures LO6, LO7 Causes of Inefficiency • Market Power • Monopoly • Nonexistence of Markets • Asymmetric information • Externality • Public good 2-4 Individual Failures Individual Failures • Like market failures, the presence of individual failures can always lead to a failure of the FWT • Individual failures: arise when individuals are not “fully rational”. Some examples include: • Inattention • Time-inconsistency (procrastination) • Preferences that depend on one’s group/identity Chapter 2 Summary • Welfare economics is the study of the desirability of different economic states. • Pareto efficiency occurs when no person can be made better off without making another person worse off. • MRSixy = MRTxy i=persons i….n • First Fundamental Theory of Welfare Economics: under certain conditions, competitive markets result in Pareto efficiency. • Second Fundamental Theory of Welfare Economics: Society can attain any Pareto Efficient outcome by making a suitable assignment of initial endowments and free trade. 2-7 Chapter 2 Summary (cont) • A social welfare function summarizes society’s preferences concerning the utility of each of its members and it may be used to find the allocation of resources that maximizes social welfare. • A possible justification for government intervention is market failure, which may occur in the presence of market power or when some markets do not exist. • The fact that the market does not allocate resources perfectly does not necessarily mean that the government can do better. • Welfare economics provides a coherent and useful framework for analyzing policy, but is controversial does not pay much attention to the processes used to achieve results. 2-8 HUMAN RESOURCE MANAGER JOB ANALYSIS Human Resource Manager Job Analysis O*NET1 and Meyer2 1 2 Human Resource Manager Summary Report Apple Inc.’s Organizational Culture & Its Characteristics 1 HUMAN RESOURCE MANAGER JOB ANALYSIS 2 Human Resource Manager Job Analysis As previously mentioned, there are several sectors in which Industrial and Organizational (I/O) psychologists can work. While Industrial-Organizational Psychology is a key specialty in improving workflow and productivity, it has found massive application in sectors such as academia, government, industry and consulting. Nonetheless, one of the occupations which persons in Industrial-Organizational Psychology can venture into is becoming a human resource manager. A human resource manager leads and directs routine duties in the human resource department. The major responsibilities of a human resource manager include developing and implementing HR strategies and initiatives, managing recruitment and selection processes and reporting to the top management about the HR department. Job Classification The human resource manager occupation is usually classified under “job zone four” since “considerable preparation is required.”. In terms of the educational requirements, a four-year bachelor's degree and several years of experience are required (O*NET, 2020). According to O*NET, “the occupational code of a human resource manager job is 11-3121.00”. They also state that some of the task requirements of human resource managers include “[serving] as a link between management and employees”. To link the two groups, human resource managers need to constantly handle any arising questions, interpret information to each and help resolve workrelated problems that any of the parties may experience (O*NET, 2020). Another task requirement is “advising managers on organizational policy matters.” They need to ensure that the interest of employees is taken into account when making these policies (O*NET, 2020). In addition to this, human resource managers also have a task to “analyze and modify compensation and benefits policies” to ensure that they are “competitive programs” and that they comply with HUMAN RESOURCE MANAGER JOB ANALYSIS 3 the law (O*NET, 2020). Most importantly, human resource managers are also required to “perform other difficult staffing duties,” especially when an organization is understaffed, there are employee disputes and when firing and disciplinary actions need to be done. Another task requirement of the latter occupation is to respond and defend organizations when their personnel are sued and during investigations (O*NET, 2020). Description of the Knowledge, Skills and Abilities To effectively execute the above tasks, human resource managers are required to have “knowledge in personnel and human resources” as well as in “administration and management” since they deal with employees directly and will be their leaders and managers (O*NET, 2020). Besides this, knowledge of the “English language, law and government” is important since they need to use good English to effectively communicate with employees and managers and understand law and government to avoid lawsuits. Most importantly, “knowledge in education and training” matters is important. Besides this, human resource managers are also required to have skills such as “active listening, speaking, management of personnel resources, judgment and decision making and reading comprehension” (O*NET, 2020). These will help them dispense their duties and interact with others. In addition to these basic skills, technology skills necessary to deal with “accounting, document management, enterprise resource planning, human resources and time accounting software” are also needed. On the other hand, human resource managers are required to have abilities such as “oral comprehension, oral expression, written comprehension, deductive reasoning and speech clarity” (O*NET, 2020). HUMAN RESOURCE MANAGER JOB ANALYSIS 4 Description of the Work Environment Human resource managers mostly work in offices which in most cases have closed designs. Some of the supervisory controls that human resource managers are subjected to include quarterly reports and audits which help the senior management track performance and also resource use. Common physical demands as a human resource manager include continuous sitting, use of fingers to feel and handle things, reaching out things using hands, talking to others, occasional incidences of standing and walking and finally lifting and moving small weights of up to 10 pounds. In most workplaces, human resource managers have high interpersonal contact and teamwork with employees and the rest of the management as evident from the work context. The human resource manager's work is averagely complex, while supervision in this position is limited (O*NET, 2020). Apple’s Organizational Culture and Competitive Environment One of the organizations in which one could work as a human resource manager is Apple. Apple's organizational culture is characterized by creativity and innovativeness (Meyer, 2019). At Apple, employees are encouraged to become creative and innovative to produce “top-notch” and value-adding products in the market. Apart from this, working under pressure to meet deadlines is another aspect of Apple's organizational culture. Typically, employees are assigned projects and given deadlines that they must deliver on time to get rewards. Despite being under pressure, employees have the autonomy to make their own decisions. Further, diversity and inclusivity are the other characteristics of Apple's organizational culture (Meyer, 2019). At Apple, the company believes that diversity brings about innovativeness and therefore, persons from different backgrounds, professions and with different abilities are involved in projects. Further, secrecy is also key at Apple. Apple's competitive environment is quite dynamic as it HUMAN RESOURCE MANAGER JOB ANALYSIS 5 deals with technological gadgets. To avoid the spilling of production secrets to competitors, employees are required to observe high secrecy within the company (Meyer, 2019). Lastly, Apple’s environment is very competitive as there exist many huge and small companies. Every day, new competitors of Apple enter the market with more innovative products while existing competitors such as Samsung, Nokia, Dell, Microsoft and HP continue to innovate better products (Meyer, 2019). All, in all, Apple is one of the best organizations in which one could work as a human resource manager and thus it is important to keep watch of its human resource management occupations as they probably hire externally to bring about new knowledge. HUMAN RESOURCE MANAGER JOB ANALYSIS 6 References Meyer, P. (2019, February 15). Apple Inc.’s Organizational Culture & Its Characteristics (An Analysis). Retrieved from http://panmore.com/apple-inc-organizational-culture-featuresimplications#:~:text=Apple%20Inc.%20has%20an%20organizational,that%20challenges %20conventions%20and%20standards O*NET. (2020, November 17). 11-3121.00 - Human resources managers. Retrieved from https://www.onetonline.org/link/summary/11-3121.00
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HUMAN RESOURCE MANAGER JOB ANALYSIS

Human Resource Manager Job Analysis
O*NET1 and Meyer2
1

2

Human Resource Manager Summary Report

Apple Inc.’s Organizational Culture & Its Characteristics

1

HUMAN RESOURCE MANAGER JOB ANALYSIS

2

Human Resource Manager Job Analysis
As previously mentioned, there are several sectors in which Industrial and Organizational
(I/O) psychologists can work. While Industrial-Organizational Psychology is a key specialty in
improving workflow and productivity, it has found massive application in sectors such as
academia, government, industry and consulting. Nonetheless, one of the occupations which
persons in Industrial-Organizational Psychology can venture into is becoming a human resource
manager. A human resource manager leads and directs routine duties in the human resource
department. The major responsibilities of a human resource manager include developing and
implementing HR strategies and initiatives, managing recruitment and selection processes and
reporting to the top management about the HR department.
Job Classification
The human resource manager occupation is usually classified under “job zone four” since
“considerable preparation is required.”. In terms of the educational requirements, a four-year
bachelor's degree and several years of experience are required (O*NET, 2020). According to
O*NET, “the occupational code of a human resource manager job is 11-3121.00”. They also
state that some of the task requirements of human resource managers include “[serving] as a link
between management and employees”. To link the two groups, human resource managers need
to constantly handle any arising questions, interpret information to each and help resolve workrelated problems that any of the parties may experience (O*NET, 2020). Another task
requirement is “advising managers on organizational policy matters.” They need to ensure that
the interest of employees is taken into account when making these policies (O*NET, 2020). In
addition to this, human resource managers also have a task to “analyze and modify compensation
and benefits policies” to ensure that they are “competitive programs” and that they comply with

HUMAN RESOURCE MANAGER JOB ANALYSIS

3

the law (O*NET, 2020). Most importantly, human resource managers are also required to
“perform other difficult staffing duties,” especially when an organization is understaffed, there
are employee disputes and when firing and disciplinary actions need to be done. Another task
requirement of the latter occupation is to respond and defend organizations when their personnel
are sued and during investigations (O*NET, 2020).
Description of the Knowledge, Skills and Abilities
To effectively execute the above tasks, human resource managers are required to have
“knowledge in personnel and human resources” as well as in “administration and management”
since they deal with employees directly and will be their leaders and managers (O*NET, 2020).
Besides this, knowledge of the “English language, law and government” is important since they
need to use good English to effectively communicate with employees and managers and
understand law and government to avoid lawsuits. Most importantly, “knowledge in education
and training” matters is important. Besides this, human resource managers are also required to
have skills such as “active listening, speaking, management of personnel resources, judgment
and decision making and reading comprehension” (O*NET, 2020). These will help them
dispense their duties and interact with others. In addition to these basic skills, technology skills
necessary to deal with “accounting, document management, enterprise resource planning, human
resources and time accounting software” are also needed. On the other hand, human resource
managers are required to have abilities such as “oral comprehension, oral expression, written
comprehension, deductive reasoning and speech clarity” (O*NET, 2020).

HUMAN RESOURCE MANAGER JOB ANALYSIS

4

Description of the Work Environment
Human resource managers mostly work in offices which in most cases have closed
designs. Some of the supervisory controls that human resource managers are subjected to include
quarterly reports and audits which help the senior management track performance and also
resource use. Common physical demands as a human resource manager include continuous
sitting, use of fingers to feel and handle things, reaching out things using hands, talking to others,
occasional incidences of standing and walking and finally lifting and moving small weights of up
to 10 pounds. In most workplaces, human resource managers have high interpersonal contact
and teamwork with employees and the rest of the management as evident from the work context.
The human resource manager's work is averagely complex, while supervision in this position is
limited (O*NET, 2020).
Apple’s Organizational Culture and Competitive Environment
One of the organizations in which one could work as a human resource manager is Apple.
Apple's organizational culture is characterized by creativity and innovativeness (Meyer, 2019).
At Apple, employees are encouraged to become creative and innovative to produce “to...


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